Read more Legal Due Diligence in China articles below >>
What is legal due diligence?
There are many forms of due diligence, for example financial due diligence undertaken by accountants to check a company’s profits, debts, solvency, financial reporting and tax status. There is also corporate due diligence concentrating on a company’s incorporation and board. Investigatory due diligence, that is looking into things such as the personal connections of management, is another area to consider especially in the context of China.
Legal due diligence however focuses on whether or not a company is complying with local and international laws and how the compliance or non-compliance will affect your investment. Performing legal due diligence will include looking into a company’s ownership of property both physical and intellectual, contracts and other agreements, litigation that it has undertaken or which has been pursued against it, as well as overlapping with other forms of due diligence in the areas of business licencing, finances, tax, and management. Legal due diligence if properly performed will also reveal what kind of company you are dealing with, are they highly litigious? Have they been prosecuted by government authorities? Or have they outsourced all of their operations and don’t actually produce anything?
Why undertake legal due diligence?
If you are considering a move into China, be it entering into a cross-border joint venture, merger or acquisition, engaging local management, or new international franchisees, partners or investors, it is important to know as much as possible before investing. Not partaking in thorough investigation can lead to nasty surprises down the track.
Performing due diligence is more than just a search for whether or not your desired company is currently complying with China’s legal requirements. If done properly legal due diligence will put your investment into industry context and show you exactly what type of business you are dealing with. By hiring professionals to undertake legal due diligence you can turn avoid unnecessary risks and confidently tap into the rapidly growing market that is China.
How do you go about it? What areas should you concentrate on?
The process of legal due diligence is basically a process of collecting information and being able to understand what it tells you and how it fits together. That having been said knowing what to look for, which questions to ask, and where to go are often less than straightforward, especially in China.
The first thing to do when undertaking legal due diligence is to talk to a professional, in most cases a specialist law firm, and explain to them what you are planning to do, for example are you investing in a joint venture, buying a company outright, or establishing a franchise. This will help a firm understand what they need to look for and which laws must be complied with.
Then the process will generally move to requesting documents, such as articles of association and business licences, from the company itself as well as China’s regulatory bodies and courts.
Go Local
Undertaking legal due diligence in China may have the same basic goal as in any other country, that is to understand and assess the investment risk you are planning to take, however the methods differ. Most of the Western world has relatively centralised and open documentation of the legal particulars of registered companies, in China on the other hand you will find much is still done at a provincial level. Therefore the next essential step is to visit the province, and site of the company you are investing in.
It may sound ridiculous but an important part of legal due diligence is verifying that the company you plan to contract with actually exists; some western investors have been caught out in the past purchasing non-existent companies. This will also give you a chance to see how the business operates on the ground and speak to management and employees.
As mentioned you will also need to visit local authorities such as the local Estate Bureau to verify the land rights you are being sold, and the local Administration of Industry and Commerce (AIC) to check the company’s incorporation documents and business licence. In the case of legal due diligence a trip to the local court will also be essential.
Important Areas
Legal due diligence will cover many of the areas of financial and corporate due diligence as well as some discrete areas of its own such as intellectual property and the search for past, present, and even pending and future litigation. The following are the main areas to consider when undertaking legal due diligence.
Real Property
In China a company will have either ‘granted’, being full ownership, or ‘allocated’, the right to use the land for a particular time and purpose, land rights. These land rights obviously have different values, thus verifying exactly what type of land rights you are getting as part of your deal is important for checking that the price has not been inflated. It is also important to find out if there are any restrictions on a company’s land use. This can be done at the local Estate Bureau by seeking the company’s land ownership certificate/s. It should also be noted that in some rural areas land rights are held by a ‘village collective’, and the head of the collective needs to sign their approval before any transfer can take place.
Also in relation to real property, check the environmental regulations for the area in which the business is located.
Intellectual Property
This includes trademarks, patents, copyright, and technology licensing. Here you need documentation of ownership or a license agreement for all IP that is being used by the Chinese company. Keep in mind that if you need to acquire the IP rights of a Chinese company in order for you to carry on its operations assignments of these rights take time, the firm who is performing your legal due diligence might be able to advise you on drafting an agreement about the use of IP rights while you are waiting for an assignment.
Also check that the company is not infringing anyone else’s intellectual property rights. And something that is often overlooked, check who the company’s IP rights may be licenced to, for how long, and whether or not this is in line with your plans for the company.
Incorporation
In this area legal due diligence will overlap with corporate due diligence, however it is important from a legal perspective to know that a company has been properly incorporated and licenced. Documents to look at are the company’s articles of association, documentation appointing the board and management, as well as any shareholder agreements that might be in place. This information should be obtainable from the local AIC. It is also imperative to check that a business has all the licenses required to carry out its current operations, and to check that the scope of these licenses will cover any new operations that might be undertaken along with foreign investment. Business licenses in China need regular renewal so the expiry date of licenses should also be checked. Finally the name on the license should be that of the person you are dealing with, if it not find out why. Also check the registered capital amount of the company as this will affect its limited liability status.
Contracts
Legal due diligence will investigate all of the current contracts a company has. This will include any loans, supply contracts, sales and distribution contracts, and any licence agreements for IP or technology or machinery that a company has.
It is important to check employee contracts, not just those of management, to see that tax and proper wages are being paid. See if the company you are planning to invest in actually employees their workers or if it is done through a labour agency which will in turn need to be checked to see if it legitimate.
Financial statements
These will obviously also need to be looked at by an accounting firm in the course of financial due diligence, however it is also an important part of legal due diligence to check compliance with China’s Corporations Act. While financial reporting is not as transparent in China as it is in Australia the financial statements of a company can usually be obtained through the local AIC if they are not forthcoming from the company itself. The basic thing to check is that the books are not misleading, the company is not trading while insolvent, and that tax regulations are being complied with.
Litigation
As mentioned above checking to see whether the target company has any legal liabilities, such as infringing another’s intellectual property, is an essential part of legal due diligence. However equally important is knowing if the company has previously had any suits brought against it and what the outcome was. If a company has previously been prosecuted by the Ministry of Commerce, China’s corporate regulatory body, then investment may not be the wisest idea as no government favours are likely to be forthcoming. It is being able to see this bigger picture which makes legal due diligence by professionals the smartest course of action to take if investing in China.
Debts and other liabilities
Obviously it is important in terms of risk management to know what debts and liabilities a Chinese company has both short and long term. This includes loans, ongoing contracts, and of course any pending and future litigation.
Document List
The following is a non-exhaustive list of the types of documents we consider will be looked at when performing legal due diligence:
- Land ownership certificates
- IP ownership and licence agreements
- Articles of association
- Documents appointing the board
- Business licences
- Loan agreements
- Current contracts- including sales, sub-contracts, licence agreements for any machinery or technology
- Employment contracts
- Financial statements (‘the books’)
- Any other debts
- Past and present legal claims brought against the company, and any which the company has brought itself
Should I hire a professional?
Investing in China can be extremely lucrative, or extremely difficult, a large part of the difference comes from proper research of which thorough legal due diligence is a large part. It is important to consider not just the obvious areas where legal compliance is necessary such as business licencing and land rights, but to delve deeper and look at a company’s past, especially litigation. Hiring professionals is the way to ensure that the information you discover is accurate, and put together to see the whole picture of a company, thus avoiding even the less than obvious risks.
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PDF Disclaimer: The above information provided by Inveiss Legal Pty Ltd is intended only as a guide. The impact of laws can vary widely based on the specific facts of each case. Further, given the changing nature of laws and the inherent speed of electronic communication, there may be inaccuracies in the above information. As such, this information is provided on the understanding that Inveiss Legal Pty Ltd is not rendering any legal advice or services. The information contained herein is not a substitute for qualified, independent legal advice and the same should be sort prior to engaging in any activity relating to the above subject-matter.
Although we have made every effort to ensure the information has been obtained from reliable sources, Inveiss Legal Pty Ltd is not responsible for any errors or omissions. In no event will Inveiss Legal Pty Ltd, or its directors, agents or employees, be liable for any decision made, or withheld, in reliance of the information contained herein.
